How the world’s largest fund managers got it wrong when Quantitative Easing did not cause global inflation

In 2008, in response to the collapse of Lehman Brothers and start of the Global Financial Crisis, the US Fed responded by slashing interest rates and then introducing “Quantitative Easing”, otherwise known as QE

In hindsight, the Fed’s move to QE coupled with China’s stimulus policies, probably saved the world from a far more severe recession than the one we experienced. Yet at the time, the outcry was loud. Warren Buffett said, “I think QE opens up certain dangers in terms of people worrying about the United States printing money”. The world’s largest bond fund manager, PIMCO, warned the world that inflation was about to explode. Our RBA predicted inflation would rise beyond the top end of its 2-3% pa target range.

Years later, inflation failed to explode as PIMCO predicted and it hasn’t risen to the top end of the RBA’s target band as they predicted. In fact, global inflation fell as QE ramped up.

Looking back, it is quite likely financial markets would have been worse without QE. Regardless, the predictions of hyper inflation turned out to be wrong and in PIMCO’s case, it was horribly wrong. Its prediction meant that PIMCO, led by “bond-king” Bill Gross at the time, was positioned for a rise in long term bond yields whereas they actually fell.

Each passing year the number of the predictions for rising inflation and bond yields increased from PIMCO and other global fund managers as columns in the AFR attest. All assumed that either QE would push up inflation or conditions would ‘normalise’. Even today, low yields persist. Many are therefore asking why “printing all that money” did not produce hyper inflation as it always has in the past.

The theory

Printing money (a common euphemism for making more money available) per se doesn’t cause inflation. But if a government prints more money and puts it in the hands of consumers, either through easier lending conditions, lower taxes or social security, eventually they create too much demand for goods relative to supply. Because there won’t be enough goods to meet demand, the businesses selling those goods naturally put up prices, hence the link to inflation.

Germany’s response to the massive debts it faced post WW1 created the term “printing money”. Forced to pay massive reparations to their European neighbours, Germany started printing Marks to buy foreign currency to cover those debts. But by printing more currency, they drove down the demand which resulted in the value of the Mark falling from 4.2 Marks to the USD in 1918, to 320 Marks to the USD by 1921. Yet printing continued to accelerate, the Mark continued to fall, prices rose and unfortunately more printing was ordered. Eventually, hyper inflation kicked in and the currency fell until one needed 4.2 trillion Marks to buy one USD.

So when QE was announced in response to the GFC, it was seen as printing money because it involved guaranteeing banks a buyer of last resort should they need liquidity. Because the central bank had announced it was buying such large volumes, the banks knew they would have access to practically limitless liquidity.

The action was supposed to encourage banks to lend more money to consumers and businesses, safe in the knowledge that they could always sell assets to the central bank if another credit crisis like the GFC striked. In theory, more lending meant more “printing” of money that should eventually lead to more inflation – the basis for hyper inflation and rising rate forecasts

Why it has been different this time

There are three compounding reasons why all that “printing” did not wind up creating excess demand and therefore inflation:

Loose credit in the early 2000s had to be repaid During the early years of 21st century, the western world was facing a natural economic slowdown due to years of slowing productivity and baby boomers retiring. In response, the western world eased monetary conditions not through lower rates at first, but through more flexible banking regulations which allowed more consumer lending, particularly in the form of mortgages. Higher consumer demand meant higher demand for the production of goods and services, which meant more businesses investing in capacity. Consumer credit bought forward spending, but eventually it had to be repaid, slowing demand. That occurred dramatically with the end of the housing bubble in Europe and the US and consumer spending was replaced by increased savings.

Surplus industrial capacity China’s economic miracle of the 1990s turned the country into a very powerful industrial engine by the early 2000s. It invested massively in industrial capacity and created jobs for the world’s largest underutilised labour force. By the time the GFC struck in 2007/08, global production capacity was already facing significant surpluses, particularly in China, Japan, South Korea and the US. The sharp drop in demand in Europe in (2007) and then the US in (2008) meant that surplus capacity could only be addressed by lowering factory prices or shutting capacity altogether. The US and Europe shut capacity often because the debt used to finance production could not be met. China, on the other hand, responded to the GFC by encouraging a massive increase in new capacity. For example, China’s steel production capacity doubled in five years from 2008, with China accounting for 73% of the world’s total capacity increase through the 2005 - 2015 decade. Those surplus capacities, at a time of very weak demand for the US, Europe and Japan, meant severely depressed producer prices and therefore lower consumer inflation. Shuttered manufacturing and retail in the US and Europe meant lower demand for labour resulting in lower wage growth and less inflationary pressure.

The digital economic revolution, or “Amazon Inflation” Today the digital economic revolution, lowering costs and thus working against inflation has created new headwinds. This impact has only really taken full effect since 2014-15 according to our numbers, but it has stepped up where the deflationary impact of China’s low cost labour has left off. This impact will last for many more years, as we have suggested previously in this article.

It is probably untrue to say that QE did not cause inflationary pressure, however one can equally argue that QE did not cause hyperinflation for the simple reason that there was a very unusual combination of exceptionally weak demand and exceptionally high supply.

Now as we near the end of 2017, Australian inflation data continues to weaken. Utility prices and tobacco added more than 50% of total CPI in the past year, and what’s worse, tobacco was actually a greater contributor than utilities. One could possibly argue that utilities inflation relates to economic health (and not government inaction), but tobacco’s impact on inflation is nothing but tax increases given that demand is actually falling sharply.

Conclusion

Hindsight tells us that some of the world’s most renowned investors, like Warren Buffett and PIMCO, got it completely wrong when forecasting the impact of QE on inflation and interest rates. Year after year, most economists and forecasters continued to predict QE would eventually bring inflation back and lead to rising interest rates.

Meanwhile, a smaller but growing voice has suggested that “this time it is different” due to the disinflationary pressures of falling demand from retiring populations, China maintaining and even encouraging excess production capacity, and the impact of the digital economy.

Lower inflationary pressures are likely to become a feature of the global economy until industrial capacity eases back in line with demand and the peak impact of the digital economy has passed. Industrial capacity could ease when China’s credit boom ends, but the digital economy will still provide at least a decade of major economic structural changes.

Without inflation to get in the way, and with record levels of government debt in the US and Europe and household debt in economies such as Australia, central banks will likely leave rates much lower than historic levels for at least the next 10-20 years.

Lower-for-longer, according to this argument, is a feature of interest rate markets for several years to come and investors should position themselves for such conditions before the bulk of financial markets catch up.

Disclaimer The contents of this document are copyright. Other than under the Copyright Act 1968 (Cth), no part of it may be reproduced or distributed to a third party without FIIG’s prior written permission other than to the recipient’s accountants, tax advisors and lawyers for the purpose of the recipient obtaining advice prior to making any investment decision. FIIG asserts all of its intellectual property rights in relation to this document and reserves its rights to prosecute for breaches of those rights.

Certain statements contained in the information may be statements of future expectations and other forward-looking statements. These statements involve subjective judgement and analysis and may be based on third party sources and are subject to significant known and unknown uncertainties, risks and contingencies outside the control of the company which may cause actual results to vary materially from those expressed or implied by these forward looking statements. Forward-looking statements contained in the information regarding past trends or activities should not be taken as a representation that such trends or activities will continue in the future. You should not place undue reliance on forward-looking statements, which speak only as of the date of this report. Opinions expressed are present opinions only and are subject to change without further notice.

No representation or warranty is given as to the accuracy or completeness of the information contained herein. There is no obligation to update, modify or amend the information or to otherwise notify the recipient if information, opinion, projection, forward-looking statement, forecast or estimate set forth herein, changes or subsequently becomes inaccurate.

FIIG shall not have any liability, contingent or otherwise, to any user of the information or to third parties, or any responsibility whatsoever, for the correctness, quality, accuracy, timeliness, pricing, reliability, performance or completeness of the information. In no event will FIIG be liable for any special, indirect, incidental or consequential damages which may be incurred or experienced on account of the user using information even if it has been advised of the possibility of such damages.FIIG Securities Limited (‘FIIG’) provides general financial product advice only. As a result, this document, and any information or advice, has been provided by FIIG without taking account of your objectives, financial situation and needs. FIIG’s AFS Licence does not authorise it to give personal advice. Because of this, you should, before acting on any advice from FIIG, consider the appropriateness of the advice, having regard to your objectives, financial situation and needs. If this document, or any advice, relates to the acquisition, or possible acquisition, of a particular financial product, you should obtain a product disclosure statement relating to the product and consider the statement before making any decision about whether to acquire the product. Neither FIIG, nor any of its directors, authorised representatives, employees, or agents, makes any representation or warranty as to the reliability, accuracy, or completeness, of this document or any advice. Nor do they accept any liability or responsibility arising in any way (including negligence) for errors in, or omissions from, this document or advice. FIIG, its staff and related parties earn fees and revenue from dealing in the securities as principal or otherwise and may have an interest in any securities mentioned in this document. Any reference to credit ratings of companies, entities or financial products must only be relied upon by a ‘wholesale client’ as that term is defined in section 761G of the Corporations Act 2001 (Cth). FIIG strongly recommends that you seek independent accounting, financial, taxation, and legal advice, tailored to your specific objectives, financial situation or needs, prior to making any investment decision. FIIG does not provide tax advice and is not a registered tax agent or tax (financial) advisor, nor are any of FIIG’s staff or authorised representatives. FIIG does not make a market in the securities or products that may be referred to in this document. A copy of FIIG’s current Financial Services Guide is available at www.fiig.com.au/fsg.

An investment in notes or corporate bonds should not be compared to a bank deposit. Notes and corporate bonds have a greater risk of loss of some or all of an investor’s capital when compared to bank deposits. Past performance of any product described on any communication from FIIG is not a reliable indication of future performance. Forecasts contained in this document are predictive in character and based on assumptions such as a 2.5% p.a. assumed rate of inflation, foreign exchange rates or forward interest rate curves generally available at the time and no reliance should be placed on the accuracy of any forecast information. The actual results may differ substantially from the forecasts and are subject to change without further notice. FIIG is not licensed to provide foreign exchange hedging or deal in foreign exchange contracts services. FIIG may quote to you an estimated yield when you purchase a bond. This yield may be calculated by FIIG on either A) a yield to maturity date basis; or B) a yield to early redemption date basis. Some bond issuances include multiple early redemption dates and prices, therefore the realised yield earned by you on the bond may differ from the yield estimated or quoted by FIIG at the time of your purchase. The information in this document is strictly confidential. If you are not the intended recipient of the information contained in this document, you may not disclose or use the information in any way. No liability is accepted for any unauthorised use of the information contained in this document. FIIG is the owner of the copyright material in this document unless otherwise specified.
The FIIG research analyst certifies that any views expressed in this document accurately reflect their views about the companies and financial products referred to in this document and that their remuneration is not directly or indirectly related to the views of the research analyst. This document is not available for distribution outside Australia and New Zealand and may not be passed on to any third party without the prior written consent of FIIG. FIIG, its directors and employees and related parties may have an interest in the company and any securities issued by the company and earn fees or revenue in relation to dealing in those securities.

Subscribe to The WIRE newsletter

About FIIG

At FIIG, fixed income is our sole focus. We enable investors and issuers to directly access a broad range of fixed income products and services. Not only do our customers have the most up to date market research and the expertise of our in-house professionals at their fingertips, they also have access to deposit rates from an extensive range of APRA regulated banks, credit unions and building societies. At FIIG we're guided in everything we do by our clear and single-minded purpose: Creating access to fixed income investments you can trust.

FIIG provides general financial product advice only. For a copy of our disclaimer please refer to fiig.com.au/disclaimer* Based on FIIG’s high yield sample portfolio. Click here to view. Subject to change and before fees. Please see our FSG for any applicable fees.